World Risk Developments March 2014

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Crimea, commodity prices and China in the spotlight

The period since our last newsletter on 28 February has been an eventful one. The US, EU and several other countries, including Australia, imposed sanctions on Russia after it annexed Crimea. Commodity prices took a tumble on fears about China, which continued to send out weak economic growth signals and signs of financial instability. In response, the authorities eased policy, but also removed their implicit blanket guarantee of corporate debt and made the exchange rate more flexible. In the process, they have reduced the risk of a hard economic landing.

Sanctions begin to have visible effects on Russian economy

The sanctions have provoked a moderate market selloff, and will be a drag on an already sluggish Russian economy. Our base case does not foresee the crisis escalating to the point where comprehensive sanctions are imposed that knock the Russian economy into crisis. But we acknowledge the situation is fluid and has potential to worsen.

The sanctions are being implemented in stages. In Stage 1, the EU and US agreed on March 6 to impose asset freezes and travel bans on a group of senior Russian and Ukrainian officials who ‘undermine democratic processes and institutions in Ukraine’. Stage 2 is now underway and responds to the annexation. In this stage, the US has expanded its list to include associates of President Vladimir Putin, and a bank (Bank Rossiya) that they control. Meanwhile, the EU is considering lengthening its list of names.

Both Washington and Brussels have also promised to consider a Stage 3 if Moscow escalates the crisis further. The G7, European Council and European Commission issued a joint statement on March 24 saying, ‘We remain ready to intensify actions including coordinated sectoral sanctions that will have an increasingly significant impact on the Russian economy, if Russia continues to escalate this situation’. Energy, banking and finance, and weapons procurement are reportedly the most likely targets for such sanctions.

Sanctions are also being implemented by Japan, Canada and Australia. Canberra’s impending sanctions are here.

In financial markets, the ruble has fallen almost 8% since the anti-government protests in Ukraine intensified in mid-January. In an attempt to stabilise the market, the central bank has raised its interest rate 150bp to 7%. The Moscow stock market has also fallen, by 14% since the start of 2014. But it rallied strongly after President Vladimir Putin said that he was not seeking to split Ukraine. Recall also that the Ukrainian/Crimean crisis got underway as a more general emerging market selloff was happening.

Wheat and corn prices have jumped sharply, because Ukraine and Russia are both leading world producers of those grains.

In energy markets, oil prices spiked almost US$2 in one day as Russian troops entered Ukraine, but then quickly retraced. Gas prices have risen by only 2%.

There have also been reports of overseas financiers adopting a wait-and-see position on new corporate and project financings, but none of any difficulty with interbank funding.

Both Standard & Poor’s and Fitch have revised their outlooks on Russia to negative from stable, but reaffirmed their ratings, including BBB long term foreign currency ratings.

Forecasters have marked down their GDP guesstimates for 2014 from 1.3% to 0.8%, but most foresee economic expansion of around 2% in 2015. They could well change their tune, however, if sanctions escalate or the economy is hit with some other setback, such as an oil price decline, because the economy is already travelling at close to ‘stall speed’.

So far no country seems inclined to impose financial or economic sanctions with real teeth. The EU is particularly worried about its dependence upon Russia as an energy supplier and export and investment destination. The EU as a whole receives around 30% of its natural gas imports from Russia, and some countries such as Poland are almost wholly dependent for their gas on Russia. For many EU countries, trade and investment ties outside energy are also strong. Germany sells more than 3% of its exports to Russia, equivalent to 1.3% of German GDP. Three hundred thousand German jobs are estimated to depend on trade with Russia, and German companies have FDI worth €20b in the country.

Even if economic sanctions are eventually imposed, the Russian economy has some strength to withstand them. It gained investment grade credit ratings in 2003 – BBB (S&P, Fitch), Baa1 (Moody’s). Thanks to current account surpluses, the country is also a small net external asset holder. The chief weakness is the banking system, which has a BICRA rating from S&P of 7 out of 10. This puts it in the fourth worst category out of 10 for system-wide risk.

Only comprehensive sanctions would be certain to exact an economic toll with which the economy would struggle to cope. Such measures would include Iran-style financial sanctions that cut off Russian banks from the international financial system and an energy embargo that denies energy suppliers many of their overseas customers. These could push the economy into both a slump and financial crisis.

But the situation, though fluid, is a long way from that. More likely than the crisis escalating to the point where comprehensive sanctions are imposed is an outcome where the Crimean annexation is grudgingly accepted, if not formally recognised.

The downside scenarios include an outbreak of violence between pro- and anti-Russian groups in eastern Ukrainian cities outside of Crimea, and an outbreak of irredentism in the former Soviet Union. As regards the latter, Transnistria has contacted Moscow about joining Russia, provoking alarm in Moldova and Romania. Transnistria is an enclave of predominantly Russian speakers that broke away from Moldova in 1990. In addition, the Transcarpathian Rusyns, an ethnic minority living near Ukraine’s border with Hungary, have asked Moscow for help to oppose Ukrainian nationalists.

Even if the crisis is contained, it is likely to have wider repercussions. The EU and US are both reportedly considering options to reduce dependence upon Russian gas. Britain, meanwhile, is pushing the EU to adopt a 25-year energy security plan that would substitute imports of US shale gas and Iraqi natural gas for Russian natural gas. In the EU, shaking loose from Russia could involve reconsidering policies to phase out nuclear power. In America, it will favour those calling for deregulation of gas exports.

None of these developments will necessarily change much the balance of supply and demand in the world gas market, and hence the price. But they could have profound impacts upon the geography of the world gas trade.

Commodity prices tumble on Chinese worries

Prices for Australia’s major commodity exports have fallen sharply over recent weeks, on fears of growing defaults among highly geared Chinese companies in an economy undergoing slowdown.

In many cases the falls have been to multi-year lows (see charts). The concern isn’t just that defaults (see story below) and declining growth will dent commodity demand directly. Commodities are often used as collateral in Chinese corporate financing, so default and asset liquidation could add to the downward pressure on prices.

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Beijing eases policy after Chinese growth slows

The government appears to be easing policy to combat the slowdown.

Recent data releases indicate a significant deceleration over January-February, with year on year growth rates for industrial production, fixed asset investment, retail sales and property sales all down. Subdued exports, a slowdown in public investment and tighter credit conditions appear to be the main drags.

In response, the government has cut the interbank rate and allowed the renminbi to slide. There is also speculation that it will use fiscal policy to buoy demand if need be. Finally, at the National People’s Congress on 5 March Premier Li Keqiang said the national growth target for 2014 would be held at 7½%, rather than lowered to 7% as some had been speculating.

But moves to increase market disciplines

At the same time as Beijing has been easing macroeconomic policy, it has also allowed the country’s first onshore corporate bond default and made the exchange rate more flexible. This is a sensible mix of policies to avoid a hard economic landing.

The default was by a small Shanghainese solar power firm named Chaori. It follows closely on the heels of defaults by shadow banks on ‘wealth management products’ offering investors returns of 9-11%. In response, Premier Li Keqiang said more defaults on financial products were likely, though they wouldn’t be allowed to threaten financial stability. In allowing China’s first onshore corporate bond default, Beijing is attempting to limit moral hazard and overzealous and mis-priced credit extension.

Meanwhile, on March 17, the central bank doubled the daily trading limit for the renminbi exchange rate – its first widening since 2012. The aim is to deter speculators from thinking they can make a safe one-way bet by buying the renminbi. It will also help the bank to tighten monetary policy so as to rein in credit expansion.

Both the removal of the blanket financial guarantee and the widening of the renminbi’s trading band demonstrate the government’s commitment to reform, even if this means damping short term growth. It also shows confidence that the economy is resilient enough to withstand the imposition of market discipline.

Roger Donnelly, Chief Economist
rdonnelly@exportfinance.gov.au

Cassandra Winzenried, Senior Economist
cwinzenried@exportfinance.gov.au

The views expressed in World Risk Developments are Export Finance Australia’s. They do not represent the views of the Australian Government. The information in this report is published for general information only and does not comprise advice or a recommendation of any kind.  While Export Finance Australia endeavours to ensure this information is accurate and current at the time of publication, Export Finance Australia makes no representation or warranty as to its reliability, accuracy or completeness.  To the maximum extent permitted by law, Export Finance Australia will not be liable to you or any other person for any loss or damage suffered or incurred by any person arising from any act, or failure to act, on the basis of any information or opinions contained in this report.